Financial stability is essential for the success of SMEs. A way in which a business can highlight problems before they become a more serious issue and keep on top of financial health and performance is by regularly monitoring ratios.
Whether there’s too much debt or inventory, expenses aren’t being managed effectively or lack of efficiency is holding companies back, all of this can be highlighted with financial ratios.
Financial stability gives business owners the peace of mind that day-to-day obligations can be met alongside investment for future growth and reserve funds in case of emergencies.
There are many financial ratios that can help organisations calculate financial stability and maintain a positive cashflow whilst managing reasonable debt.
Current Ratio = Current Assets ÷ Current Liabilities
The current ratio measures current assets like inventory and receivables to determine whether there is enough to cover short-term obligations within 1 year.
Also known as working capital ratio, if the current ratio is greater than 1, businesses are able to settle any debts using existing assets.
Quick Ratio = (Current Assets − Inventory) ÷ Current Liabilities
Similar to current ratio, quick ratio also identifies a company’s ability to pay its debts but the calculation removes the inventory so it only looks at liquid assets. Also known as acid test ratio, it’s a much more effective ratio for product-based businesses. A result above 1 indicates the business can cover short-term responsibilities.
Days Working Capital = ((Current Assets – Current Liabilities) x 365) ÷ Revenue from Sales
Days of working capital ratio simply calculates how many days are needed to convert working capital into sales which can then be compared with industry competitors. The result identifies how efficient a business’ working capital use is, so a low number indicates high efficiency and a high number indicates low efficiency.
Debt-to-Equity Ratio = Total Liabilities ÷ Shareholders’ Equity
The debt-to-equity ratio helps a business understand how much of it is funded through debt which consequently gives owners a clear idea of the company’s financial structure and any risk factors.
It helps to show where companies are taking on too much debt, increasing the risk of meeting payments in the future. If a business’ debt-to-equity ratio is around 2/2.05, this is typically considered a good ratio; any higher than this, then it signifies the company is financed through debt.
It’s important to note though that companies with consistent cashflows might be able to sustain a higher ratio without running into problems.
Debt to Total Assets = Total Debt ÷ Total Assets
Instead of indicating how much a business is funded by debt, the debt to total assets ratio calculates the percentage of a business’ assets that are financed by creditors.
A low ratio below 1 identifies organisations that have more assets than liabilities which is promising for investors. A high ratio means a company has to pay out more profits towards interest payments which isn’t very attractive.
Interest Coverage Ratio = EBIT ÷ Interest Expense
Interest cover ratio is quite self-explanatory. It calculates how operating income covers interest payments, therefore measuring comfortability for the business. For example, a high ratio suggests that company has enough financial stability to pay their debts comfortably.
Simply put, profitability ratios are used to determine the profitability of a business; so, how much money a business is making or losing.
These ratios are essential to understanding the financial viability of a business compared to other businesses within the same industry.
Calculating profit margin over multiple years enables owners to compare the ratios and identify any trends in the profit margins. These trends can then be used as a comparison between other organisations and their performance.
Gross Profit Margin Ration = (Net Revenue − COGS) ÷ Net Revenue × 100%
Gross profit margin ratio refers to the amount of money a business has left after paying all direct costs of producing and purchasing the products or service they offer.
Also known as just gross margin, the ratio specifically refers to the percentage of revenue. The higher the percentage, the more money the business can afford on indirect costs and expenses.
Net Profit Margin Ratio = Net Income ÷ Net Sales
Net profit margin ratio refers to the percentage of sales left over after paying all businesses expenses, so shows owners how much profit is coming in.
A good ratio varies industry-by-industry, so compare the results against competitors to evaluate performance.
Overall, though, the higher the net profit margin, the more efficient a business is. It also highlights their adaptability and ability to take on new opportunities.
Return on Assets = Net Income ÷ Average Total Assets
Return on Assets (ROA) evaluates performance based on a business’ profits compared with the capital invested in assets.
This is another ratio that is useful to look at over time in order to see if businesses are getting more profits out of each pound in assets and are efficiently using economic resources.
An increasing ROA indicates high efficiency, but a decreasing ROA can show that it might be time to evaluate where investments are hurting the business.
Return on Equity = Net Income ÷ Shareholders’ Equity
The impact of a shareholder’s investments into a business can be shown through return on equity (ROE) ratio as it can calculate profits.
Again, a good ROE can vary from industry to industry and there are some useful resources online to aid with benchmarks.
EBITDA Margin = EBITDA ÷ Revenue × 100
(EBITDA = Net Profit + Interest + Tax + Depreciation + Amortisation)
The EBITDA margin helps to give businesses a clear view of operational performance by removing financing decisions and accounting policies, so it’s easier to assess acquisition value.
An average of around 15-20% EBITDA margin for SMEs is considered healthy, however it’s vital to consider growth development and capital intensity when comparing businesses.
Inventory Turnover = Cost of Goods Sold ÷ Average Inventory
Inventory turnover focuses on the movement of stock and how many times inventory is sold/replaced within a certain timeframe.
There is no one-size-fits-all “good” inventory turnover as it varies by industry, but as a general rule of thumb:
By focusing on the trend of inventory turnover, owners can evaluate results and compare against competitors to gauge performance. A declining turnover ratio may suggest excess stock or poor sales which can lead to a cashflow problem however, at the other end of the spectrum, a very high turnover may suggest a high chance of running out of stock.
Debtor Days = (Accounts Receivable ÷ Revenue) × 365
Debtor days is a different type of ratio as it gives a measurement in days, rather than percentage. It calculates the average time customers take to pay an invoice after its issued.
Anything between 30-45 days marks an average for SMEs and above 60 days can be a warning sign of cashflow problems.
Receivables Turnover = Net Annual Credit Sales ÷ Average Accounts Receivable
Receivables turnover is used to compare sales made on credit within a company’s credit policies and payment terms. Whether they are receiving customer invoice payment within their credit terms or outside of them can indicate if their process needs evaluating or not.
SMEs should monitor multiple ratios together and over time to build a bigger picture of financial stability. One ratio cannot provide enough insight to determine this.
It’s recommended that ratios are reviewed every quarter and have set target ranges based off the industry, competitors and growth stage they operate within as this can provide useful context.
Businesses should always investigate why any changes in trends, rather than single figures, have occurred as this could highlight potential issues or just simply be a miscalculation.
If a business is new to financial ratio tracking, remember to start small so it’s not too overwhelming. By focusing on a few useful ratios and KPIs this can create a useful starting point.
There is not a “good” universal finance ratio because they are susceptible to different industry standards. The economic climate, business model and sector the business operates in will have different levels of success, so no one ratio can reflect that.
The main issue SMEs face with financial figures is how they are interpreted. By tracking ratios over time, businesses can easily identify emerging risks early enough to tackle them before they spiral into bigger issues. They also help make informed decisions to improve profitability and performance.
Lucy Turner is a Content Marketing Specialist crafting creative copy for website projects and marketing campaigns. Whether it’s blogging, content optimisation, email and social media content or website messaging, her writing skills translate across all channels.
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